Wednesday, January 20, 2010

Why Government Spending Does Not Stimulate Economic Growth

The fact that government failed to spend its way to prosperity is not an isolated incident:

During the 1930s, New Deal lawmakers doubled federal spending--yet unemployment remained above 20 percent until World War II.

Japan responded to a 1990 recession by passing 10 stimulus spending bills over 8 years (building the largest national debt in the industrialized world)--yet its economy remained stagnant.

In 2001, President Bush responded to a recession by "injecting" tax rebates into the economy. The economy did not respond until two years later, when tax rate reductions were implemented.

In 2008, President Bush tried to head off the current recession with another round of tax rebates. The recession continued to worsen.

Now, the most recent $787 billion stimulus bill was intended to keep the unemployment rate from exceeding 8 percent. In November, it topped 10 percent.[2]

Congress cannot create new purchasing power out of thin air. If it funds new spending with taxes, it is simply redistributing existing purchasing power (while decreasing incentives to produce income and output). If Congress instead borrows the money from domestic investors, those investors will have that much less to invest or to spend in the private economy. If they borrow the money from foreigners, the balance of payments will adjust by equally raising net imports, leaving total demand and output unchanged. Every dollar Congress spends must first come from somewhere else.

Removing water from one end of a swimming pool and pouring it in the other end will not raise the overall water level. Similarly, taking dollars from one part of the economy and distributing it to another part of the economy will not expand the economy.

But savings do not drop out of the economy. Nearly all people put their savings in: (1) banks, which quickly lend the money to others to spend; (2) investments in stocks and bonds; or (3) personal debt reduction. In each of these situations, the financial system transfers one person's savings to someone else who can spend it. So all money is quickly spent regardless of whether it was initially consumed or saved. The only savings that drop out of the economy are those hoarded in mattresses and safes.

Accepting that domestic borrowing is no free lunch, some analysts have asserted that foreign borrowing can inject new dollars into the economy. However, these nations must acquire American dollars before they can lend them back to Washington. Foreign countries can acquire American dollars by either:

Attracting American investments in their country. In that instance, the dollars leaving America match the dollars lent back to America. The net flow of saving circulating through the U.S. economy does not increase.

Selling goods and services to Americans and receiving American dollars in return. For the United States, these imports raise the trade deficit and thus reduce domestic demand. The government's subsequent borrowing back and spending of these dollars merely offsets the increased trade deficit.

In either situation, American dollars must first leave the country before they can be lent back into the U.S. economy. The balance of payments between America and other nations must net zero. Consequently, government spending funded from foreign borrowing does not provide stimulus.

Thus, not all tax cuts are created equal. The economic impact of a tax cut depends on how much it alters behavior to encourage labor supply or productivity. This productivity standard is the same as the one applied to government spending in the previous section.Tax rebates fail to increase economic growth because they are not associated with productivity or work effort. No new income is created because no one is required to work, save, or invest more in order to receive a rebate. In that sense, rebates that write each American a check are economically indistinguishable from government spending programs. In fact, the federal government treats rebate checks as a "social benefit payment to persons."[20] They represent another feeble attempt at creating new purchasing power out of thin air rather than focusing on productivity.

Tax rebates in 1975, 2001, and 2008 all failed to create economic growth. By contrast, large reductions in marginal tax rates in the 1920s, 1960s, and 1980s were each followed by large surges in economic growth.[21] More recently, the 2003 tax-rate reductions immediately reversed the job losses, sinking stock market, declining business investment, and sluggish economic growth rates that had followed the 2000 recession.[22] These gains continued until unrelated economic developments brought the most recent recession in December 2007.[23]